Saturday, February 26, 2011

Normalized Earnings - Berkshire Hathaway 2010 Annual Report

Warren Buffett is fantastic at making arcane accounting accessible to an average investor. But it can be hard to go from his big picture analogies to the detailed figures that make up the published financials.

This year he introduced an important new metric to the report -- Normalized Earnings. He offers no details on how he came up with the figure, ($12 billion), but it is simply another approach to separate the noise of short term fluctuations from the underlying, core value of the firm.

This figure is another approach to complement the two principle metrics he has always used. That is -- for the short term, operating earnings and for the long term, change in book value (shareholder equity).

Buffett defines normalized earnings as, "... a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006." And he has selected a figure of $12 million as his estimate.

He once again discusses the long term (46 years) metric he has consistently shown at the beginning of each annual report -- change in Book Value.

"To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance....Yearly figures, it should be noted, are neither to be ignored nor viewed as all-important. The pace of the earth’s movement around the sun is not synchronized with the time required for either investment ideas or operating decisions to bear fruit."

To demonstrate the value of this metric over intermediate time periods, the report (page 5) includes the exact same data aggregated into rolling 5 year periods. This exhibit is striking in regard to the extent to which the figures stabilize and present a much clearer picture of past performance.

This works particularly well for Berkshire, since it doesn't pay dividends. Book value is the aggregate of the entire financial history of the firms -- and includes all capital gains -- both realized and unrealized. And all the exceptions that are typically excluded from operating earnings.

Later in the report, a discussion of operating earning vs net earnings repeats numerous prior discussions:

"Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours."

Net earnings are a GAAP figure that is meaningful for most businesses, but is severely flawed for a firm with a large investment portfolio and atypical derivative contracts. Operating earnings exclude the change in derivative liabilities as well as realized capital gains and losses.

Since 2006, Berkshire has issued a press release with the non GAAP operating figures reconciled with the GAAP net income figures. They have included this statement (from 2007):

"In our earnings summary, we distinguish between what we call “operating earnings” and investment and derivative gains/losses. Berkshire possesses a huge reservoir (about $35.5 billion on June 30, 2007) of pre-tax unrealized investment gains. The cashing of these in any given quarter (or the realization of losses, for that matter) can materially distort net income figures as well as comparisons between periods. We do not wish investors to mistakenly focus on a bottom-line number affected by large investment gains that do not stem from economic accomplishments during the reporting period and that have no concurrent impact on the intrinsic value of the company. Both trends in our operating businesses and their health are best judged by income before all investment gains or losses."

The only thing missing from this explanation is the implicit assumption that the only additional information is the latest quarter's data. Everything else has already been published and presumably included in valuation of the company. Another way of stating this is that over a single quarter, operating earnings are much more appropriate for a firm like Berkshire than GAAP net income. The quarterly press releases stress this both in quarters where the headline net income figure is higher as well as lower than operating earnings.

Page 33 of this years annual report:

This is a GAAP exhibit and reconciles the balance sheet to the income statement -- and illustrates the various items that impact the change in book value other than net income. The largest is 'Other Comprehensive Income" and includes unrealized capital gains -- which is shown in detail on page 33:

Note that over the 3 year period, the largest items - unrealized capital gains/losses and their tax impact - net to a modest figure. This reflects the market crash in 2008 as well as the stock market recovery in 2009 and 2010.

Net income is clearly a better proxy for earning power (for lack of a better term) than comprehensive income. However, it includes realized capital gains/losses and derivative gains and losses. And also remember that GAAP is designed for all businesses in all industries -- and most businesses don't have any derivatives and have modest capital gains/losses.

" After-tax investment and derivative gains/losses were $1.87 billion in 2010, $486 million in 2009, $(4.65) billion in 2008, $3.58 billion in 2007 and $1.71 billion in 2006."(page 27)

The net income for 2010, 2009, and 2008 of $13.0, $8.1, and $5.0 billion, less derivative and investment gains/losses, are the operating earnings of $11.1, $7.6, and $9.6 billion. The three year average net income was $8.7 billion vs average operating earnings of $9.4 billion.

The 2010 operating earnings of $11.1 billion as well as the three year average of $9.4 billion provide a lot of support for the new metric, normalized earnings, estimated at $12 billion.

[end of part 1]